In practical terms, the notion of dominant position coincides with the notion of market power, that is, the ability of a firm to consistently present prices above marginal cost, without suffering significant losses in sales (profits). As I will argue in this text, the problem is not market power by itself, but its abuse. Actually, a dominant firm has access to a set of instruments in order to perform such abuse. The list, not intended to be exhaustive, may include prices, delimitation of markets, contracts and other trading conditions, but also the access to essential facilities, which will be covered here in greater detail.
In order to spell out my reasoning, I should start by using a twofold approach to tackle the concept of market power: while it incorporates some negative aspects, they are not negative enough to justify the elimination of market power as an objective to be pursued by Competition Policy (ignoring the practical considerations of how to achieve that).
From Industrial Economics, we know that an unconstrained firm with significant market power will produce less and charge a higher price for its output when compared to the competitive case. In this sense, market power reduces allocative efficiency, that is, some units are not produced for which consumers would be willing to pay more than the social marginal cost of production. Moreover, since rates of innovation also tend to be lower, we may note the existence of dynamic inefficiencies. Finally, we can think, especially in the extreme case of market power (monopoly), about losses in technical efficiency – the firm will not produce at its minimum opportunity cost.
Everything that I mentioned in the last paragraph explains why Competition Policy should be concerned with market power. However, as economists, we must recognize the role of incentives in economic agents’ decisions. It is the prospect of gaining some market power (and more profit) that represents the most powerful incentive for firms. Without such a powerful incentive, would firms be interested in innovating or investing? Would they be interested in staying in the market? The answer is obviously no, because firms must be able to benefit from the rewards of their investments. If firms use more efficient technologies, they can improve the quality of their products and also increase the variety. And, logically, consumers will benefit from this.
Now, I will introduce in the discussion the delicate issue of essential facilities doctrine. I have written “delicate” because it justifies some caution and requires its application only in truly exceptional circumstances. Indeed, the spectrum of expropriating firms’ assets and having rivals free-riding on investment are almost always present in this type of competition cases.
When a given input is considered as being indispensable to all participants to operate in a certain industry, and whose replication is considered practically and reasonably impossible, it has been classified in the literature as an “essential facility”. Some classical examples include slots in airports, port infrastructures, railway bridges, certain chemical components, etc. Although these theoretical examples may seem clear-cut, it is rather difficult to evaluate if a given facility is essential or not. It is also true that, meanwhile, new input sources – given they are appropriate substitutes – may emerge. On the other hand, nature by herself may impose a limit on resources availability (e.g. diamonds, gold, aluminum or even some fruits), explaining why some monopolies were sustained.
Refusal to access (or to supply) can also be included in the category of raising rivals’ costs strategies (e.g. allowing access only at an extremely high price or obliging competitors to exert effort in looking for a substitute input). By raising the cost of one or more rivals, the dominant firm (owner of the facility) can increase prices without losing market share. This seems particularly attractive for those firms wishing to pursue an anti-competitive behavior in order to deter entry. Contrarily to predatory pricing strategies that require great losses in the short-run (requiring the “deep pocket” or “long purse” hypothesis), raising rivals’ cost has an immediate impact in entry decisions.
For instance, let us assume a simple Cournot duopoly, with an incumbent and a candidate to entry. As we know, by the structure of the maximization problem and then looking to the best response functions, increasing the fixed costs of the entrant will not affect the quantity it decides to produce. However, it will be reflected on its decision to enter or not. If the incorporation of this higher fixed cost in the profit equation yields negative profits for the entrant, then staying out of the market will be a better solution. In the same way, if the incumbent is able to increase the marginal cost of the entrant, the entrant will surely produce a lower quantity. Since quantities are strategic substitutes, the incumbent’s best response is to be more aggressive and thus increase production. Consequently, if the entrant’s variable profits are not enough to cover the fixed costs, the incumbent will be once again successful in pursuing an entry deterring strategy, safeguarding its monopolist position.
Furthermore, if one firm invests substantially in R&D in order to offer a better product to its customers, this also increases the rival’s costs in the sense that, if the rival wants to keep competitive, it will have to replicate that investment. However, this practice does not hinder competition – as mentioned before, it will benefit consumers and increase their welfare.
The abuse of dominance is surely one of the most difficult topics to deal in Competition Policy. In part, because there are several ways of gaining market power. Some examples include superior management, economies of scale and exclusionary practices. The topic of essential facilities is itself somewhat ambiguous to analyze. In fact, I must recognize some vagueness in the own definition of an essential facility. Are we always sure that there are no other substitutes? And how costly and difficult should the duplication of that facility be?
To conclude, we are all aware of the benefits of competition both in static, with lower prices and better quality of products, and in dynamic terms through innovation and efficiency gains. However, obliging a firm to give access to an essential input to a competitor might have the effect of discouraging future investments. Therefore, that is why I recommend some caution when applying the essential facilities doctrine. As it is usual in Economics, the answer might not be on the extremes but, perhaps (with some creativity), somewhere in between.
About the author: Tiago Silva (Lisbon, 1990), awarded by the Portuguese Ministry of Education (2008), holds an Undergraduate Degree in Economics by Nova SBE (2011) and he is currently finishing his Master in Economics also at Nova SBE. His main fields of interest cover broadly Microeconomics and, particularly, Economic Regulation and Industrial Organization.